Original title: the US energy industry is in a "shrinking state", but it is a good thing for investors
Public attitudes towards energy companies are changing, followed by shrinking capital investment in energy companies. Perhaps nothing is more persuasive than action. In the first quarter of 2021, investment in funds focused on environment, society and governance (ESG) hit an all-time high.
Meanwhile, capital investment by American energy companies is at its lowest level since 2004. In other words, the energy industry is in a state of shortage of funds.
When we compare capital expenditure with depreciation expenditure, the concept of capital scarcity is very clear. As shown in the following figure, a ratio above 1 indicates that the asset expands after deducting depreciation, while a ratio below 1 indicates a contraction in the asset base. At present, the capital of energy companies is shrinking at the fastest rate on record. In the most recent quarter, only 44% of depreciated assets were replaced by new assets.
The problem is that us oil production may not be stable at current levels if only 44 per cent of assets are replaced by new capital spending and energy capital expenditure levels remain at this level. Investors may also need to seriously consider whether U. S. crude oil production can return to a high of about 12.5 million barrels a day in the foreseeable future.
Of course, if consumption of crude oil and natural gas shrinks, the shrinking fossil fuel industry is not a big problem. But even with a significant share of renewable energy, gasoline and natural gas consumption will rise steadily by 2050, according to the U.S. Energy Information Administration.
Due to the lack of capital, rising consumption and flat or falling production seem to be a good thing for the price of gasoline products and for the fundamentals of the energy companies themselves. In fact, over time, free cash flow does track the level of capital expenditure very well, and the 17-year low of capital expenditure may indicate that the free cash flow of energy companies will reach the highest level in at least a decade.
While the fundamentals of energy companies may be improving, valuations remain low, in part because of the trend of investors to adopt ESG strategies at an extremely rapid pace. For example, the absolute price-to-book ratio is still close to its lowest level in the past decade.
To sum up, for investors who prefer to increase their positions against the trend, proper buying of these capital-starved energy sectors may pay off.